Inventory on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

When looking at a company's current assets, you need to pay special attention to its inventory. Inventory consists of merchandise a business owns but has not yet sold. Because investors assume that inventory can be sold in the near future, turning it into cash, it is classified as a current asset. For certain types of businesses, inventory on the balance sheet is among the most important items you'll need to analyze because it can give you insight into what is happening with the core business in ways nothing else can.

Inventory Accounting Methods

To come up with a balance sheet estimate of inventory, companies must use different rules and methodology to account for the goods. Most common methods include the FIFO inventory method, which is the "first in, first out" method and the LIFO inventory method, which is the "last in, first out" method. In addition, there is "percentage of completion" inventory method, which is particularly useful for the pro-rated recognition of contractually guaranteed sales when the company you are studying is a manufacturer that has to physically produce the goods it must deliver.

There is the ​weighted average inventory method. There is the specific identification inventory method. How these influence both the balance sheet figures and the income statement, especially during times of inflation, is something you should understand if you hope to do well as an investor or manager.

Major Risks of Carrying Too Much Inventory on the Balance Sheet

The inventory figure on the balance sheet presents an interesting, if not unique, problem. When inventory increases, it faces three major risks that can harm the business, which I'll explain in detail below. If these risks come to fruition, they can manifest themselves in losses that reduce both the return on equity and return on assets.

Inventory Risk #1: The Risk of Obsolesce

When too much inventory remains on the balance sheet, there is a major risk of a product or products becoming obsolete. This means that the company will either be unable to sell the inventory or must reduce the price of the inventory, sometimes substantially, to sell it as there are now more attractive, newer goods on the market. When I first wrote this investing lesson back in 2001-2002, I used the example of Nintendo, the Japanese gaming giant. I talked about how the company's then-newest video game system, the Game Cube, would someday be worth far less than the value at which Nintendo carried the inventory on its balance sheet.

The reasons are not hard to understand. New gaming systems with upgraded hardware would be released and the old ones would be sold in discount stores and online auctions.

When inventory becomes obsolete, a company must reduce its value on the balance sheet by taking a write-down on the income statement. If a company habitually writes down large amounts of inventory, it could indicate that management is incompetent and highly inefficient, unable to align production and procurement with a reasonable expectation of demand. At the very least, it should serve as a major red flag, warranting further investigation.

Inventory Risk #2: The Risk of Spoilage

Spoilage is precisely what is sounds like, occurring when a product actually goes bad and cannot be sold. This is a serious concern for companies that manufacture, assemble, and distribute perishable goods. For example, if a grocery store owner overstocks ice cream, and two months later, half of the ice cream has gone bad because shoppers chose another brand of ice cream or avoided the freezer section entirely, the grocer has no choice but to throw it out. The estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet.

It's lost money.

Inventory Risk #3: Shrinkage

When inventory is stolen, shoplifted, and embezzled, it is referred to as "shrinkage". The more inventory a firm has on the balance sheet, the greater the chance it's going to be stolen. This is the reason that inventory-heavy companies with a lot of public access are so extraordinarily sophisticated at risk mitigation. To provide a real-world illustration, Target Corporation, the second largest discount retailer in the United States, has what amounts to one of the most impressive forensic investigation units anywhere on the planet.

It is so good that, far from its original intended purpose of reducing inventory shrinkage, it has helped law enforcement solve murders, rapes, arsons, and other crimes.

A good way to see how effectively management is dealing with the risk of inventory shrinkage is to compare a firm against other businesses in its same sector or industry. If you're examining a chain of drug stores and one has substantially higher losses from inventory shrinkage than everyone else in their field, it tells you that management probably needs to be replaced and there is a potential to make a lot more money as the core earnings could be higher than their present level. (This might seem paradoxical but there are times when investing in bad businesses becomes particularly profitable.)